Event Risk Financing: Thinking Beyond the Transfer versus Retain Paradigm
August 2007
Do you ever wonder why organizations spend
so much time, energy, and expense managing and financing event risk when the
most significant risks, collectively known as business risks, receive comparatively
little attention?
by Donald
J. Riggin
Albert Risk
Management Consultants
Enterprise risk management (ERM) focuses on some of these risks, e.g., financial
and operational, but for the most part, we consider "business risks" as just
the costs of doing business. For example, every year a large clothing retailer
makes bets on consumer demand and weather expectations. Despite all of the market
research, will the new purple fisherman's sweaters sell or languish on the shelves?
Will the Northeastern winter be normal or abnormally warm? Some companies use
weather insurance or derivatives to hedge against this risk, but can we hedge
against the effects of a bad business decision?
The financial consequences of discovering that buying 1,000 carloads of unwanted
purple fisherman's sweaters could be quite significant, perhaps even requiring
the company to take a hit to its earnings. The company, however, routinely assumes
this risk, hoping that next year's sweater bet hits the mark. While the company
takes no active measures to hedge against the sweater risk, it nevertheless
must finance the loss. It does so through its earnings, supported by its paid-up
capital. The company has no choice—it must have the wherewithal to finance this
type of loss.
Event Risk
We do not consider event risk in the same way. We usually think in terms
of what we should keep and what we should transfer. Ideally, we transfer the
catastrophic risk and keep the more frequent, manageable risk. The particulars
of this decision are more often than not dictated by the insurance industry.
The fact that insurance is available for event risk forces companies to use
it at least for catastrophic losses; to do otherwise would be grossly irresponsible.
What if we set aside this "transfer versus retain" mindset and focus on a
more basic question: What is the best way to finance the risk? Just because
we don't transfer does not mean that we do not have to finance it. Could that
large retailer in the above example have found a way to neutralize the risk
that purple fisherman's sweaters would not sell? The answer is yes, but instead
it chose to finance the loss nonspecifically, with its earnings and capital.
Since the retailer is a public company, its cost of capital includes something
called the beta, which is a relative measure of its earnings volatility against
the Standard and Poor's 500. Large retailers' earnings are extremely volatile
(hence the sweater example). This company's beta is around 1.17. Anything over
1 is considered volatile; a beta below 1 reflects a relative lack of volatility.
Betas in excess of 1 are considered "risk premiums" and provide a degree of
transparency to investors. The investor receives the risk premium for investing
in a company with such volatile earnings. This risk premium increases the company's
weighted average cost of capital. From the investor's perspective this means
that for the company to grow profitably, every decision involving the use of
capital must exceed its cost.
Risk Capital
So, aside from a catastrophic event risk (which we never fail to transfer
off the balance sheet), can we take a financial, cost of capital-driven, approach
as described above to event risk? More importantly, should we adopt this approach in lieu of
the standard transfer/retain assumptions? The answer to both questions is yes,
but in the absence of universally accepted metrics such as the beta, we must
devise a way to measure event risk's impact on the company's earnings and its
cost of capital. The first thing we do is identify that which we consider "risk
capital."
Risk capital, like all capital, is divided into sources and uses. The cost
of insurance premiums is a use of risk capital, while insurance proceeds (loss
payments) are a source of risk capital. Equity represents both a source and
a use of risk capital. In the absence of a formal event risk financing arrangement,
such as a captive, risk financed on-balance sheet places a burden on the company's
equity, the same as that sweater risk in the above example. The components of
risk capital are (1) transfer/hedging costs, (2) purchased off-balance sheet
risk capacity, and (3) equity.
All three components are inextricably interrelated in that the most efficient
combination requires a delicate balancing act. In the transfer/retain mindset
the only important variable is the state of the insurance markets. The conventional
thinking is that we buy as much (cheap) off-balance sheet protection as we can
afford. When the transfer markets harden, we buy less, and so forth. The insurance
markets and the availability of affordable transfer products drive our financing
(hedging) strategy. However, is this really a strategy, or just a routine exercise
that everybody uses and seems like the right thing to do? I suggest it is the
latter.
Let us look at each component's function within a financial context, and
compare it to the conventional, quite limiting, transfer/retain thinking.
Transfer/Hedging Costs and Purchased Off-Balance Sheet Risk Capacity
The costs to transfer or hedge event risk is rarely, if ever, based on the
actual amount of risk transferred; the costs are based on the amount of protection
purchased (not received). We do not purchase $100 million of products liability
insurance because that matches our actual risk, do we? Of course not. We purchase
it because of what our risk might be or could be. Therefore, it is a fallacy,
in economic terms, to suggest that the premium for that $100 million of insurance
is even close to an efficient use of risk capital. Heresy, you say!
Consider this. If we are sued for a legitimate products liability claim,
we could face bankruptcy without all of those insurance limits. Yes, you are
correct, but if your company is well run with state-of-the-art quality controls,
both physical and legal, then the chances of losing a $100 million products
liability lawsuit are very, very small.
Turning back to the large retailer example, your CEO willingly assumes the
significant amount of risk associated with your decision to buy the purple fisherman's
sweaters (which could be tantamount to a $100 million gamble), but you would
never consider not buying enormous amounts of expensive insurance to protect
the company against a loss with a likelihood of occurrence equal to a fraction of that represented by the sweater
decision. This is one example of how the transfer/retain mindset locks us into
a mode of irrational behavior inconsistent with sound economics (not to mention
the laws of probability).
Equity
We covered the first two hedging strategy components above, which brings
us to the third. Every company uses equity capital to finance event risk in
the form of deductibles and self-insured retentions. The question is not whether
the company should retain event risk (all do), the question is the impact it
has on the company's financial wellbeing.
The transfer/retain paradigm suggests that when transfer markets are hard
(expensive), we should simply retain more risk. When the CFO asks about the
costs of insurance premiums in such a market, you tell her not to worry, the
risk transfer costs are under control; we had to assume a little more risk in
our deductible. Unfortunately, neither you nor your CFO has any idea how to
measure the impact of that additional retention (or any retention, for that
matter). She congratulates you on your cost-containment "strategy." While you
and your insurance broker may have worked through one or more "selecting-a-retention"
exercises, the decision is usually made on what is considered the optimal attachment
point for the insurance, and not the company's tolerance for risk or the effect
on its equity.
Continuing with the large retailer example, let us assume that the company
has large amounts of cash and unused credit lines. This might suggest that increasing
the products liability retention from $2 million to $10 million might be okay.
Yes, it might be okay, but it might not. From a financial perspective, this
decision places a 5-fold increased burden on the company's equity. The amount
of cash on hand and the company's ability to tap credit lines are subject to
the company's earnings volatility, which is considerable, as discussed above.
By deciding to increase the retention to save money on premiums, you have added volatility to the company's already
volatile earnings. What's more, this additional volatility is not reflected
in any of the company's cost of capital metrics, resulting in no investor risk
premium and decreased transparency.
The primary question, then, is whether the additional volatility is worth
the premium savings. Probably not, but you have no way of knowing anyway.
Summary
To summarize, event risk managers (and their brokers and consultants) must
find ways to see beyond the narrow world of "transfer or retain." It should
begin by gaining a thorough understanding of your company's (or client's) financial
management goals. You should strive to find innovative ways to elevate the event
risk financing analysis process beyond the gravitational pull of the insurance
industry.
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